The Fed Gives and Europe Takes...but Quietly

We have mentioned many times that the U.S. Federal Reserve will help bail out Europe.  The rescue operation is underway...but oh so quietly. The talking heads on television, perhaps mostly on holiday hibernation, have missed the development thus far, and you may have as well unless you read a December 28 editorial in the Wall Street Journal.  It was written by Gerald P. O'Driscoll, Jr., a former senior economist and vice-president of the Federal Reserve Bank of Dallas, who is eminently equipped by education, experience, and connections to know the mechanics of the Fed.

The Fed action is surreptitious. That's because the European Central Bank (ECB) wants to provide needed liquidity to Europe's anemic banks without printing a lot of Euros. If the ECB blatantly cranks out Euros it would undermine its status as an inflation-fighting stalwart and incur the wrath of Germany. At the same time, many European heads of state want the ECB to purchase more sovereign debt, so what you have is an obvious conflict. 

The U.S. Fed to the rescue. But shhhhhhh....

Here's what's going on.  The Fed is engaging in a temporary U.S. dollar liquidity swap arrangement with the ECB. In common English, that means the Fed swaps dollars with the ECB for Euros. The ECB pays a small interest rate and guarantees to return a fixed number of dollars at a future date at a fixed exchange rate. Then, the ECB lends the money to the European banks that need it most.  In 2008, the Fed caught flak for loaning money to U.S. branches of the foreign banks, so this time they are attempting to maneuver by tip-toeing around the eggshells. 

The artful maneuvering provides cover for both the Fed and the ECB because it allows for helping European banks without printing a lot of Euros or dollars in an obvious manner.

A most important part of the story now follows: In late 2008, the Fed had $600 billion of swaps on its balance sheet. By early 2010 they were mostly paid down as the panic of 2008 subsided and banks were able to raise capital from traditional sources, primarily by selling stock. By the end of last summer, the Fed's swap renewal agreement had a balance of only $2.4 billion.  In recent weeks, the balance has grown to $64 billion.  We fully expect to see much higher numbers in the coming weeks as more dollars are channeled to Europe.

What's happening is an obscure form of quantitative easing, aka money printing; but it is a type of money printing nonetheless. Central bank balance sheets...and future generations' debt burdens continue to grow. 

In addition to the dollar funding, there are other plans afoot to further liquefy European banks and strengthen the financial backstops. It was announced, for instance, this past week that Germany has agreed to enlarge the size of the European Financial Stability Fund (EFSF), the special funding pool financed by members of the Eurozone to combat the continent's sovereign debt crisis.